Answer 1)
The nightmares of global financial crisis began in 2007 and despite the efforts of central banks and policy makers to restore the economy, the crisis were intensified in 2008. The proven impotency of policy responses and multiple views of number of economists and analysts over causes of Financial Crisis, has raised the root causes of global financial crisis.
The Sub Prime Lending:
The continued trend of increasing prices in housing sector because of excessive liberal and accomodative policy along with lax liberal standards during the period of 2002-2006, led to large issue of mortgage credit to households including sub prime borrowers.
On account of liberal lending policies supported with financial innovation, loans were issued with low margin money and low teaser payments. Due to the practised model of ‘‘Originate and Distribute’’ most of these mortgages have been mortgages were securitized. Further the sub prime lenders, bundled these mortgages into various tranches as CDO and sold them to the investors.
Further with inflation targeting US Economy during 2006, federal reserve bank adopted for strict monetary policy and with interest rate rising up mortgage payments also started increasing. With tight monetary policy, housing prices slashed and with low initial margins, the subprime borrowers decided to default as it was a great incentive to do so. Such defaults led to huge losses to banks affecting their capital largely and forcing the economy towards financial crisis.
Another fact revealed that stress tests carried out by banks that confirmed that banks were well capitalized and can deal with any financial shocks were based on outdated data relating to period of Great Moderation, which did not showed the true image to the bank and deprived them of the reality.
Secondary Reason:
Securitization:
Securitization was the main contributor to originate and distribute model which reduced the lending institution’s incentive to be prudent and led to financial crisis. In light of huge investor demand for sub prime lending, banks issued the loans and securitized them as AAA Bonds. These mortgaged backed securities were widely distributed to investors which later caused repercussions, globally, when sub prime lending went into a financial disaster in 2007.
Underestimated Risk by Credit Rating Agencies:
The credit rating agencies issued AAA ratings to most of the sub prime mortgage backed securities which were bundled into tranches by issuers. Later these securities were subsequently downgraded to junk status by same credit rating agencies. Thus excessive reliance on ratings by market forces who underestimated the risk and did not used their own due diligence research before investing in MBS, led to financial crisis.
Answer 2)
Considering the global financial crisis, an average American Citizen has been largely affected of it in following ways:
Lack of Employment Opportunities:
With both big and small businesses affcted by financial crisis and also with strict lending policies of commercial banks for lending loans, has curtailed the growth and start up of new entities thus leaving the American Citizens with low employment opportunities.
Reduced Income/Lack of Savings:
With 17% of American Citizens affected by financial crisis and many left umemployed post economic disaster in 2007, the rate of savinsg by Americans has been record low as people laid off from their jobs are relying on withdrawls of past savings.
Decreased Spending:
Fall in amount spent on consumer purchases was the most wide spread and popualr effect of financial crisis with around 30% Americans agreed to cut their purchases during 2009. Most of the decline was recorded in food purchased in restaurants as people adopted for ‘’Food In’’ than ‘’Food Out’’. Also a substantial decrease in spending on health care was experienced.
Fall in Value of Stock Holdings and House:
With housing market and stock market crashed, American Citizens were also affected by fall in value of their Stocks and House.
Answer 3)
Sub Prime Lending:
Subprime Lending is the practice of lending loans at rate higher than prime rate to those individuals who do not qualify for loans at prime rates of banks. The premium rate charged on borrowing is because of poor credit history of the borrower and the associated high risk which lending institution assumes to take is translated to higher interest rate than market interest rates.
The additional interest rate will charge some substantial dollar amount from the borrower over the whole span of borrowing.
The term was viral during the economic crisis of 2007 when large sub prime lending agencies went bankrupt on account of collective default of millions of sub prime borrowers.
Collateralized Debt Obligation:
A collateralized debt obligation is an Asset Backed Security that is collateralized by the pool of debt obligations. Example of CDO Includes:
- Corporate bonds with ratings below Investment Grades
- Bond Issues in Emerging Markets
- Corporate Loans advanced by commercial banks
A CDO have the following structure:
i)One or more of Senior Tranche:
It comprises of 70-80% of the entire deal and is assigned a floating rate payments to attract investors who are looking for a floating rate investments
ii)Several Levels of Mezzanine Tranches:
These level of tranches are assigned with a fixed coupon payment
ii)A subordinate Tranche or Equity Tranche:
This tranche is created to provide repayment and credit protection to other tranches.
Since pool of CDO collaterals contains a mix of floating and fixed rate debt instruments but since the payments to majority of tranche holders are based on floating interest rates, interest rate swaps to cover up this cash flow mismatch. Rating agencies like Moody’s and Standard and Poors have mandated inclusion of interest rate swaps in a CDO deal.
Credit Default Swap:
A derivative instrument that can help in portfolio risk by transfering credit exposure of fixed income between the parties. Under this swap agreement, the purchaser of swap makes payments to the seller of swap until the maturity and in return seller confirms creditability of the debt security which buyer is purchasing.
In other words, CDS confirms credit protection to the buyer of debt security purchaser of swap to third party(lender). Thus the risk of default of bond issuer is transferred from buyer to seller and buyer is assured of receiving par value of the contract at the maturity.
Inflation:
Inflation refers to persistent increase in the price levels over time of almost all goods and services.
There are two types of Inflation:
- Demand Pull
- Cost Push Inflation
i)Demand Pull Inflation is caused by increase in money supply, increased government spending and other causes that increases aggregate demand. With increased aggregate demand and constant aggregate supply, prices of goods and services experience upward pressure because of increased purchasing power of people and thus, the economy foresee inflationay pressures.
ii)Cost Push Inflation is caused by initial decrease in aggregate supply caused by an increase in the real price of an important factor of production such as wages and energy. The oil crisis of 1970 is the perfect example of cost push inflation.
Too Big too Fail:
A financial term coined to denote the utmost importance of large banks, financial institutions and businesses that if failed would cause a great damage to the economic structure of a country. In simple words, the terms is related to banks and other firms that would substantially damage the financial system that if these houses fails the economy might have to be at the doors of bankruptcy. Thus for this reason, government support to them in the form of Bailout Packages are necessary to support and save the economy as whole.
The theory of “Too Big to Fail” asserts the fact that financial institutions does business in such a large way and also being interconnected with other small financial institutions, failure of a large bank would also affect small banks and thus the chain leads to loss of jobs, loss of income- posing a threat to the economy.
Thus if the cost of bailout is less than cost of failure to the economy, bailout will be the most effective solution for the government to consider in general interest of the economy.
Stock Market:
Also known as Equity Market, stock market supports issue and trading of shares of companies, either through exchanges or over the counter markets. Stock Market supports two kind of markets:
- Primary Market:
These markets supports initial issue of securities by the company popularly known as Initial Public Offering.
- Secondary Market:
Subsequent trading of securities after they are alloted to general public through IPO issue, is transacted in secondary market.
Housing Markets:
Refers to Real Estate market where transaction of sale and purchase of houses is supported between buyers and sellers either through broker or directly. To estimate the sentiments of housing market, an index based on monthly survey of members of National Association of Home Builders is carried out and is represented through NAHB/Wells Fargo Housing Index.
The index and US Single Family House starts have a close correlation thus displaying current trend in new private house constructions.
Credit Rating/Credit Scores:
A financial term used to represent the credit worthiness of the borrower who can be an individual, company or their products or even a government. Such ratings are granted by credit rating agencies like Moody’s and Standard and Poors.
Credit rating have inverse relationship with possibility of debt default. A high credit rating issue indicates a good credit worthiness of the borrower while a low credit rating is vice versa to it.
Europe Crisis:
Also known as Sovereign Debt Crisis, Europe Crisis started in 2008 with collapse of Iceland Banking System. Post that several European countries faced threat of collapse of financial institutions with high government debt and rising yields on government securities.
During this period rating agencies downgraded debt issues of many European countries where at a time greek government bonds were declared as ‘Junk’’.
The crisis were supported with several bailouts from International Monetary Fund.
US Unfunded Liabilities:
Unfunded Liabilities refers to amount of current or potential debt on which there is no funding available to pay off. In other words, it is a liability or probable expense that do not have savings or investments to pay them off and the borrower is likely to use past savings or borrowings to pay off this liability.
As for federal government, the recent calculations show that comparing government liabilities and income from estimated future taxes, the total unfunded liability of US Government is $123 trillions of Unfunded Liability.
Works Cited
Jigling, Mark. Causes of Financial Crisis. Research Paper, Congressional Research Service, 2010.
Labor Union Reort Diary. Why Are We Not Talking About America’s $123 Trillion In Unfunded Liabilities? http://www.redstate.com/2013/02/20/why-are-we-not-talking-about-americas-123-trillion-in-unfunded-liabilities/ (accessed October 15, 2013).
Mohan, Rakesh. Global financial crisis - causes, impact, policy responses and lessons. http://www.bis.org/review/r090506d.pdf (accessed October 15, 2013).
National Bureau of Economic Research. The Effect of the Economic Crisis on American Households. http://www.nber.org/bah/2010no3/w16407.html (accessed October 15, 2013).
Parkin, Michael. "US Inflation, Unemployment and Business Cycles." In Economics, by CFA Institute, 168-191. Boston: Custom, 2011.
